Yesterday’s Indian Express carried a piece by me on the perverse oil subsidy that the government of India provides. I begin that piece with my favorite Douglass North quote: “Economic history is overwhelmingly a story of economies that failed to produce a set of economic rules of the game (with enforcement) that induce sustained economic growth.” I used that quote in the other piece published in Mint today.
The reason I like that quote it because it goes to the very heart of the problem of India’s economic development. Indians as a collective are no less than other collectives around the world; India is endowed with natural and human resources; yet India is desperately poor. Why? Because we have failed to develop a set of rational rules to play by. Refusing to acknowledge that failing will ensure our continued poverty.
Anyway, here’s the text of that India Express piece.
Perverse Subsidy for the Rich
Nobel prize-winning economist Douglass North observed that “economic history is overwhelmingly a story of economies that failed to produce a set of economic rules of the game (with enforcement) that induce sustained economic growth.” Producing a set of rational economic rules is a political rather than an economic process. Frequently basic economic truths are willfully disregarded in a myopic but cynically calculated process of short-term electoral gains. In the long run, however, the persistent practice of politically motivated economically unsound policies has the unsurprising and unfortunate effect of impoverishing the economy.
India is a case in point. Despite being endowed with substantial human and natural resources, it has failed to provide a vast majority of its citizens the basic necessities for a decent life. It is hard to avoid the conclusion that what India mainly lacks is a rational set of economic rules. An important contemporary example of a flawed economic policy is the subsidy that the consumers of petroleum enjoy.
The price of a barrel of crude is hovering around US$ 100 a barrel and yet the price of petrol at the pump remains essentially what it was when crude was selling at half that price about a year ago. The resultant gap between the cost and the price has to be bridged through a subsidy that is estimated to be around Rs 70,000 crores this year. The case is made that by keeping the price artificially low, the so-called “common man” benefits. But that is certainly not the case. It is a perverse and regressive subsidy for a number of reasons.
First, it is the “uncommon man” who actually benefits directly from the subsidy. In fact, the wealthier you are, the more vehicles you own, the more subsidy you capture. For every litre of petrol or diesel you consume, you benefit by around Rs 10; for every cylinder of LPG, someone else chips in Rs 250. The really poor person does not own cars nor has a gas connection.
Second, when distorted low prices do not reflect the full costs, it sends the wrong signals and consumption is more than is socially optimal. India meets about three-quarters of its petroleum needs through imports at an approximate cost of US$ 50 billion a year. Increased consumption inflates that import bill and is economically wasteful.
Third, the burden of the opportunity cost of the subsidy falls squarely on the people who cannot reap its benefits. The resources that the subsidy consumes are not available for services that the poor benefit from such as subsidies for public transportation systems, primary health and education.
Fourth, the subsidy is financed by bonds issued to oil marketing companies. These bonds represent a future liability. Essentially it is a mechanism employed by the present voting generation to secure benefits that will be paid for by the future generations who do not have a vote and therefore do not have the option to reject that burden.
Fifth, if prices were more aligned to true costs, alternatives such as better public transportation system can have a fair shot at being developed. It would also send the right signals for more conservative use of private cars, leading to less congestion and pollution.
The basic economic truth is that there is really no such thing as a free lunch. Today’s subsidy comes at a cost that will only grow larger the longer the delay in pricing petroleum products at full cost. It is fairly simple to remedy the situation. Raising the price at the pump is the simplest but the most politically risky. The UPA government knows that and will definitely not risk losing power even if raising prices is for the larger benefit of the economy.
But those subsidies have to be reduced, if not totally abolished overnight. A start could be made immediately to reduce the subsidy to the rich while continuing it for the poor. A mechanism for doing so would be to impose a tax on car owners which would reflect the full cost of the petrol they use. Depending on the size of the engine and average fuel consumption, an annual fee could be assessed which has be paid to maintain registration. So if a particular make and model of car typically consumes, say, 1,000 litres of petrol a year, the tax could be Rs 10,000.
This type of a mechanism would leave all two-wheelers, three-wheelers, and buses untouched. Since it is usually the common man who uses public transportation, the common man would continue to enjoy the subsidy.
Implementing rational economic policy is not impossible for India even though for decades on end we have been burdened with flawed policies. We are moving slowly towards a more rational way of running an economy. Whether we persist on along that path is a political matter which can only be determined ultimately by the enlightened self-interest of an educated population.
Atanu Dey : Life is a Random Draw 
Thank you Thank You. I have been telling this to people for a long time. The 70,000 crore free gift by the GOI to its rich citizens could have done wonders to ensure that every child gets food & education, but that wouldn’t win them any elections. So we continue these perverse economic policies, snatching the future from poor and feeding the rich man’s car.
I have a general question for you Atanu, a lot of what you write is based on a sound economic & common sense, do you think anyone would listen and if not what do we do?
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My arithmetic is not so good (being a victim of Indian Education), if someone can look at the numbers and shed some light, that would be great.
In US, a gallon (3.78 liter) of gas = $3 at pump, about $0.80/liter, should be about Rs. 32/liter.
Of the cost of gas at pump, 20% is stolen as taxes and Oil cos make huge profits as well.
http://www.eia.doe.gov/bookshelf/brochures/gasolinepricesprimer/eia1_2005primerM.html
http://taxprof.typepad.com/taxprof_blog/2005/10/gas_taxes_excee.html
I’m not sure of petrol rate in India, I’m assuming it is between Rs. 47 – Rs. 50, which is 50% higher than in US.
If Oil companies in US can make huge profits (and pay more than that in taxes) at Rs. 32/liter, I wonder why Oil companies in India are in losses at 50% more.
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indlinginc:
your very strong arithmetic brings us to the next logical question.
1- Who were the ones opposing oil company privatization in India (that Arun Shourie tried to do) and why?
2- The same day that Atanu published this in the Express; the same paper carried a report that said a political party would do a nation-wide agitation against Petrol price hike (you guessed it – it is Shourie’s party; the BJP)
3- Let’s put Atanu’s figure of 70,000 cr in petro-subsidy in perspective. Forecast (record) tax collection this year is estimated to be 300,000 Cr. We throw away nearly a QUARTER or our earnings subsidising petrol/LPG for the rich. Imagine you are a struggling poor parent in India. What would you do to a son that frittered a quarter of your income on paying for his booze and prostitutes ? (ok. a little extreme – but you know oil is an addiction too).You would kick him out – instead the government of India coddles him.
Imagine if we subsidised bio-fuel research and production to that extent. Would we not be able to find a way to put money into the pocket of the rural farmer instead of the Arab Sheikh?
India’s governance structures are still colonial in the sense that they are exploiting the poor to pay for the luxuries of the rich. Laughably over here the allegedly pro-poor communists are batting for the car owning rich
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Ghostwriter,
I totally agree that the rich – to be more specific, upper middle and middle class, the layer that is commonly known as govt servants are benefited.
1. Jobs are created and preserved for them.
2. No one else is allowed to compete in their areas – state monopolicies – resulting in massive inefficiencies.
3. Education is highly subsidized for the rich – (Atanu’s – Who Paid for My Education?)
4. LPG, Petrol, Diesel, Public Transportation (mostly urban areas), Electricity, etc
5 – 100. And the list goes on…
Strange as it may seem, I am not outraged by this subsidization of the rich. Allow me to explain my reasons.
Asheesh claims that the 70,000 crores would do “wonders to ensure that every child gets food & education”.
You claim that we should use the same money for subsidizing biofuel research. Lets say alternative energy. I would say alternative energy and not biofuel, because biofuel has a water dependency, something that we can’t rely on a decade or two from now. http://technology.newscientist.com/article/mg18925401.500
Both Asheesh’s and yours are perfectly laudable expenses (we can debate some on that). However, you have not established how 70,000 crores not spent by Govt in these subsidies is going to result in spending the areas you suggested. These 70,000, if not spent this way, would result in more asinine projects, maybe buy some defence junk or some idiotic irrigation projects. The margins for politicians are massive in any of these spendings – I’m sure they would make 50,000 crores easily.
However, money given as petrol subsidies is not easily stealable by the politicians. I’m all for cutting money supply to the politicians. If we can give away all 300,000 crores as petrol subsidies, we should. When there is no money, the politicians miraculously disappear. This will usher in a new era of a market forces.
All I’m saying is, perhaps this 70,000 crores is a more equitable distribution. Why should the politicians steal all the money? Give some to their servants as well. After all they are called Govt servants!
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And thru this subsidization, inefficient users survive. Efficiency measuered as perunit money output with per unit oil used.
By facing real market forces, efficiency can be encouraged.
However if i could i wouldnt change everything overnight i would explain the exact formula by which subsidies are going to be phased out
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Atanu,
Your arguments are correct, and they make mathematical sense. However, I think that if we were to suddenly increase the price of petrol, then every commodity will get incredibly expensive. The lower middle class and the people who sell vegetables and other commodities in the daily market: they will be the worst hit, since they _have_ to pay for using petrol-run vehicles for their transport. That trickles into everything… bus fares, movie tickets, barbershop: how do we deal with that?
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Its an interesting article, although, I find Atanu’s way of subsidy-rebuttal is myopic for the following reasons:
1. It totally ignores the democratic political process / will. Political cadres represent the majority of Indian VOTING population.! To really make a difference, start voting the political agenda of your choice to power !
2. Does not consider the effects on inflation when one abruptly removes subsidy. Inflation needs to be controlled in a sustainable fashion. Otherwise it can be a demon. Imagine, inflation spiralling 10-11 % they way rupee has against dollar in a single financial year.
3. Subsidy is kind of payback to the taxpayer. A tribute to the taxpayer. A sort of intangible benefit for paying taxes honestly. Not all money should go to the gas-less, land-less poor ! It is a very similar argument by some folks that suggest to divert all money from defence expenditure to social causes – to fight poverty, promoting primary education healthcare etc. !
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Agree with Sudipta and Abhijeet. Whether there is subsidy or not, the main problem is that a huge amount of our earnings go abroad to sustain our transportation infrastructure. And that IMO is the main problem.
Removing subsidies will only distribute the burden over the entire population making economic growth slower and whatever opportunities that poor are getting today from participating in the economy.
The main problem is about finding a more fundamental lasting solution to our transportation problem.
It would do good for the government to keep the subsidies (and get vote banks) as well as to encourage growth in areas like alternative fuel and mass transport in a holistic form involving R&D, manufacturing, distribution and adoption.
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Lets seee why this scenario wouldnt lead to inflation.
You Buy something for Rs10 sell it for Rs8, to cover your loss you spend 1 from taxes and issue bonds for the other 1….To cover for that Rs1 you print more money.
And PS Rs rising against $ is a good thing.
Its due to the demand for Rs. This is due to increasing indian productivity in few sectors.
And since oil is purchased mostly in $ its better wrt oil purchases.
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